Index funds and exchange traded funds offer advantages

Although they may do well in any one year, most managed mutual funds do not consistently beat the market. For this reason, many individuals prefer index funds, which don’t attempt to pick and choose stocks of individual companies or try to time the market, says Pat Swanson, CFP® and families specialist with Iowa State University (ISU) Extension’s Invest Wisely Project (www.extension.iastate.edu/investwisely). “An index fund tracks a particular group of stocks, for example the S&P 500 is made up of large companies, the Russell 2000 Index of small companies, and the Wilshire 5000 is a total market index.”

An index fund gets the same returns as posted by the index it tracks minus the annual fees involved in running the fund. “Generally the expenses are low because there is no need for analysts deciding when to buy or sell securities,” Swanson explains. “Historical data show that index mutual funds have a lower expense ratio than the average managed mutual fund.”

Index funds also are tax efficient. “There are capital gains when you sell your index fund, but because the fund’s manager does not buy and sell frequently as with a managed mutual fund, typically taxable distributions include only dividends,” Swanson says.

“The new kid on the block is exchange traded funds (ETFs),” Swanson adds. “They are the fastest growing segment of the fund industry.” They are similar to mutual funds in that they hold a basket of securities – stocks, bonds, currencies and commodities are common. The first ETFs included the securities that make up an index such as the S&P 500. The newer ETFs target specific market sectors such as transportation stocks.

Swanson says the expense ratio of exchange traded funds is on average even lower than that of index mutual funds. They also are tax efficient, similar to index mutual funds.

“Unlike mutual funds, ETFs are traded on exchanges where you can buy and sell them throughout the day like stocks,” Swanson points out. “The biggest drawback to ETFs is the brokerage commission you pay each time you buy or sell. If you are an investor who dollar cost averages by regularly putting a smaller amount into an investment, you may be better off using a no-load index mutual fund.”

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The ISU Extension Invest Wisely Project provides a series of newspaper, radio, and web resources for investors.  It is funded by a grant from the Investor Protection Trust (IPT).  The IPT is a nonprofit organization devoted to investor education.  Since 1993 the IPT has worked with the States to provide the independent, objective investor education needed by all Americans to make informed investment decisions.  www.investorprotection.org.